SBA ACCOUNTING DEFICIENCIES

Our accounting system has not been responsive to our needs and has been subject rightfully to criticism by the GAO and others. These criticisms have been brought to your attention. I have ordered a complete overhaul to bring the system in line with GAO standards. This will be accomplished by the end of this fiscal year.

IMPAIRMENT OF CAPITAL

Impairment of capital is one of the most serious problems for the Government, for the SBIC, for private investors, and for small business concerns which rely upon SBIC's as a continued source of funds. By regulation, we define impairment as a loss of 50 percent or more of the privately invested capital. An impairment is a violation of our regulations. Where actual losses occur, a fairly uncomplicated situation exists. The real problem arises when a portfolio evaluation is required before a finding of impairment can actually be made. Obviously, the SBIC is reluctant to establish a loss reserve where the possibility of recapture or possible gain may occur. Our own loss estimating and portfolio evaluation have been deficient. Consequently, each SBIC must be continually reviewed by SBA and evaluations kept current.

I have directed that appropriate steps be taken to identify potential impairment cases early, before the impairment stage becomes an actuality.

We are also studying the possibility of amending the impairment definition, to better protect the Government's investment.

PROBLEMS OF DELAY IN DEALING WITH VIOLATORS

There are problems of delay in dealing with violators. I outline them as follows:

A. Licenses under present law may be suspended by administrative proceedings. However, a civil action must be brought in a U.S. court to revoke a license. A quicker more effective tool is needed. I favor legislative authority to SBA for administrative license revocation, subject to appropriate safeguards and court review.

B. Since SBIC assets-frequently including Government fundsmay evaporate quickly, it is necessary that SBA be able to move rapidly to insure that the funds are not dissipated pending the completion of the administrative or the judicial process. We are presently studying proposals to enhance the speed and the effectiveness of both processes. When we have had the opportunity to study these proposals fully, and have satisfied ourselves that they will reach the objectives we seek, while preserving the rights of all parties, we may have appropriate recommendations to make to the Congress.

C. The committee staff has been furnished information with respect to the cases referred to the Department of Justice for civil and criminal action. We recognize that there have been delays in handling these cases. We are working with the Department and are confident that the problems confronting us can be resolved quickly and on a mutually satisfactory basis.

I have taken other action to improve the program. I am proposing legislation that section 201 of the Small Business Investment Act be

amended to delete specific reference to a Deputy Administrator for Investment and to an Investment Division to eliminate any doubts that the Administrator only has full authority and responsibility for the SBIC program.

I have determined that no funds under either section 302 or 303 will be made available without my personal approval.

Senator MUNDT. May I inquire whether that has not been the procedure earlier, up to now, that the Deputy Administrator would handle the whole deal without even consulting with you?

Mr. BOUTIN. The real problem, Senator, is in the past because of the section of our statute which specifies a Deputy Administrator for Investment and an Investment Division to run this program, the Administrator had in fact dubious control at best, or authority, over this program. So, in fact, in the past it has been run pretty much by the Deputy Administrator.

Now, even with the law as it is now, this has not deterred the present Administrator from moving hard on these programs, but I think for the clarity of the future, we would be much better off to have those references deleted. In the past, the Administrator, to the best of my knowledge, has not had a voice, as an example, in release of funds, in approval of loans.

Senator CURTIS. May I ask right there, has the Deputy Administrator in the past been an administration direct appointment and one not made by the Administrator?

Mr. BOUTIN. No, always in the past, Senator, the Deputy Administrator, as is the case with all employees of the agency, is directly appointed by the Administrator. Of course, many times these have been gained by inheritance when he came into the program. I have inherited the choices of many other people.

Senator MUNDT. Is the Deputy Administrator under civil service? Mr. BOUTIN. It is a schedule C, so there is some latitude.

Senator CURTIS. How many have there been since that position was created?

Mr. BOUTIN. I think we are on our fifth one, Senator, if I am not mistaken. Mr. Greenberg is the fifth one.

Senator HARRIS. Will you finish up, Mr. Boutin, and then we will have some other questions.

Mr. BOUTIN. Thank you.

I would like to conclude, Mr. Chairman, by stating that I believe the SBIC program is needed by the small businessmen of this country. It is faced with many serious problems, some of which could not have been anticipated, lacking precedent as a guide. I have full confidence that in the months ahead, results will prove the wisdom of the Congress in enacting this legislation.

Mr. Chairman, I have four exhibits to submit at this time.

Exhibit I summarizes the legislative history of the Small Business Investment Act, as amended.

Exhibit II summarizes the status of problem SBIC's as of June 30, 1966.

Exhibit III lists current licensing standards for SBIC.

Exhibit IV (a) through IV (d) is a statistical summary-I must admit a very complicated one-and, among other things, it shows the trend of the program from its inception to the present.

Mr. Chairman and members of the committee, I thank you for giving me the opportunity to present this statement, and I stand ready to try to answer questions that you may direct to me.

Senator HARRIS. Thank you, Mr. Boutin.

I want to say that the subcommittee certainly appreciates the cooperation you have given as preparation has been made for these hearings. We appreciate your statement. Without objection, the exhibits will be made a part of the record. (The exhibits referred to follow :)

SMALL BUSINESS ADMINISTRATION

EXHIBIT I

A REVIEW OF THE LEGISLATIVE HISTORY OF THE SMALL BUSINESS INVESTMENT ACT AS AMENDED

Prior to passing the Small Business Investment Act of 1958, Congress requested several studies of the gap in long-term loans and equity capital available to small firms. The best known of these studies was made by the Federal Reserve Board in 1957, after which Chairman William McChesney Martin concluded:

"There is a gap in the existing structure of financial institutions which lies in the long-term debt and equity capital areas ***” He suggested, * * * A Government program to foster the flow of private investment funds to small business."

Congressional support of this concept was also strong. Senator John Sparkman stated in his introduction to the Act's Committee print, "With the passage of the Small Business Investment Act on August 7, 1958, a serious gap in the financing facilities available to small firms was bridged * * * this legislation should greatly increase the flow of long-term debt and equity capital to many small companies which have desparately needed this form of financial assistance in order to grow and prosper."

Provisions of the Act

The Small Business Investment Act created a Small Business Investment Division (SBID) within the Small Business Administration. It gave this division the authority and responsibility to license, regulate, examine, and lend funds to Small Business Investment Companies (SBICs). These SBICs were authorized to make long-term loans to small businesses, and to purchase convertible debentures from them. It is significant that in the original Act, convertible debentures—that is, interest-bearing notes with a right to convert into stock, were the only means by which SBICs were allowed to supply equity capital to small concerns. It is also significant that the Small Business Investment Division was to have no direct contact with small firms financed by SBICS.

The Act said that a small business investment company had to have a paidin capital and surplus of at least $300,000 before it could open for business. SBA could supply up to half of this amount by purchasing subordinated debentures of the new company. These subordinated debentures were considered part of the "statutory capital" to meet the minimum capital requirement of the Act. The debentures were also the basis for additional loans from SBA, the "line limit," and the maximum borrowings by the SBIC.

Additional loans from SBA were to encourage the growth of the SBICs and could amount to as much as 50 percent of the statutory capital of a company. Thus, an investment of $150,000 in private capital made an SBIC eligible for $300,000 from SBA-half in subordinated debentures and half in the form of an operating loan under Section 303 of the Act. This provided a two-to-one ratio of Government funds to private money for a minimum-size SBIC.

Section 304 of the Act said a primary function of an SBIC was to provide equity capital for small business by purchasing convertible debentures. These debentures could be converted, at the SBIC's option, into stock of the small business at the "sound book value" to be determined when the debentures were issued.

The SBIC could require the small business it financed to refinance all its debt with the SBICS. It could also require it to obtain SBIC approval of any additional debt, and to give the SBIC first opportunity to finance such debt.

The act also sought to broaden the ownership of the SBICs and eventually to reduce their reliance on government funds. A small business receiving capital from an SBIC had to buy stock in the SBIC equal to at least 2 percent but not over 5 percent of the amount of capital supplied.

The Act also allowed SBICs to make long-term loans to incorporated and unincorporated small businesses, and permitted SBICs to furnish consulting services for a fee. SBA was given the authority to prescribe operating regulations, conduct examinations and obtain reports. SBICs violating the Act or Regulations could be enjoined from doing so upon application by SBA to a United States District Court, and could be required by the Court to forfeit their license, upon suit brought by the United States.

The Small Business Investment Act also provided tax advantages to encourage the SBICS. Taxpayers investing in the stock of small business investment companies were allowed an ordinary loss deduction rather than a capital loss deduction on losses incurred in sale or total depreciation of such stock. Similarly, SBICs were allowed an ordinary loss deduction rather than a capital loss deduction on convertible debenture losses including losses on stock received when their conversion privilege was exericsed.

In addition, SBICs were allowed to deduct 100 percent of dividends received from taxable domestic corporations, rather than the 85 percent deduction allowed to corporate taxpayers generally.

Experience Under the Original Act

Experiences of the first group of SBICs licensed soon made it plain that the Act had shortcomings. The limitation that said capital could be provided only by using convertible debentures was too restrictive. Both SBICs and small business agreed that it was essential to tailor financing to the needs of the business. For instance, a desirable combination might include a long-term loan and the direct purchase of stock. Moreover, small business frequently objected to having to use even a small part of their funds to buy stock in the SBIC.

'The 1960 Amendments

In June 1960, the Act was amended to provide that SBICs could supply equity capital to small firms "in such manner and under such terms as the small business investment company may fix in accordance with the Regulations of the Administration.

The 1960 Amendments also deleted the requirement that the provision of equity capital be a primary function of the SBIC. Instead, this became only one of their functions.

The troublesome requirement that small concerns obtaining capital had to buy stock in the SBIC was replaced by a provision that gave them the right to buy such stock if they so elected.

Amendments to the Internal Revenue Code in 1959 also exempted SBICs from classification as personal holding companies, so long as they were actively engaged in supplying funds to small businesses in which their own shareholders had no more than a 5 percent direct or indirect ownership.

The 1961 Amendments

During 1961, the Act was amended again. SBICs were given additional authority to participate with other lenders. The maximum of $150,000 which SBA could supply to SBICs for capital purposes was raised to $400,000 provided matching private funds were invested in the SBIC.

The original Act permitted SBA to make operating loans to SBICs up to 50 percent of their statutory capital. The 1961 Amendments limited the amount of such loans to $4 million or 50 percent, whichever was less.

By increasing the amount of permissible bank investment in an SBIC from 1 percent of capital and surplus to 2 percent, the 1961 Amendments provided further encouragement to banks to take part in the SBIC program.

SBA was also given authority to conduct administrative proceedings leading to show-cause orders, and cease-and-desist orders, and suspension of licenses. Revocation of licenses continued to require a United States Court proceeding but additional investigation authority was given to SBA.

The 20 percent line limit of SBICS was amended to forbid any credit of more than $500,000 to a single small business unless prior SBA approval was obtained.

The 1963 Amendments

The so-called Amendments of 1963 (which actually passed in February 1964) allowed a further increase in the matching funds-subordinated debenture provision, from $400,000 to $700,000. At the same time, a five-year-time limit was placed on the availability of this amount. The amendments removed the controversial $500,000 limit to one small business. They also required SBA to adopt regulations to deal with conflicts of interest.

STANDARDS FOR LICENSING SMALL BUSINESS INVESTMENT COMPANIES

1. Full-time qualified officer in charge of operations, compensated at prevailing levels for comparable employment (107.102(d)(1)).

2. Background record of each officer, director, and shareholder owning 10 or more percent of licensee's stock must be acceptable to SBA (107.102(d) (2)).

3. At least 5 directors required, 40 percent of whom are independent (107.102 (d) (3)).

4. Three unrelated shareholders, each owning 10 or more percent of a licensee or other acceptable diversity of ownership (107.102(d) (4)).

5. Licensees must have a reasonably accessible office adequately staffed (107.102(d) (5)).

6. Must establish need (107.102(d) (6)).

7. Licensee may not place more than one-third of its portfolio in real estate investments (107.102(d)(7)).

8. Licensee must furnish adequate assurance that it does not as a regular part of its business, plan to self-deal (107.102(d) (8)).

9. A 2 year projection of operations is required (107.102(d) (9)).

10. $300,000 of minimum initial private capital (107.102(d) (9)).

11. A stockholder owning 10 or more percent of the stock of a licensee must have a net worth at least twice the amount of any funds borrowed to purchase stock (107.102(d) (10)).